Real returns and dividends

The power of the long term

IT IS worth returning to the long-term study by Deutsche Bank, because it contains so many rich details that all investors ought to study it.

Take the widespread belief that investors should be indifferent, except for tax reasons, as to whether cash is paid out to them as dividends, or reinvested in the company. If the money is reinvested, then earnings will grow faster; after all, isn't a dividend payout a sign that management has no ideas? Technology companies often don't bother to pay one.

But a look at history should disabuse investors of that notion. The key period is the late 1950s where, in America and Britain, the dividend yield on the market dropped below the government bond yield for the first time. Institutional investors reasoned at that time that the dividends on a diversified pool of equities would grow sufficiently to offset the loss in immediate income. From that point, the payout ratio also started to fall; from 69% pre-1958 to 46% since then.

So did earnings grow faster once companies cut their payouts? Up to a point. The real rate of earnings growth edged up from 1.3% to 1.8% a year but that failed to compensate investors for the fall in the average dividend yield from 5.2% to 3.2%. Rather than using the spare cash to boost earnings, companies wasted it (probably by paying it to executives, who have become massively richer over the period.) A high dividend is a good discipline on managers.

A related issue is that, in real terms, equity prices can fail to rise for an extended period; in 1982, the S&P 500 index was no higher, after adjusting for inflation, than it had been in 1929. All the real return over that period would have come from dividends so the starting yield is very important to future returns. And the yield is currently low.

Another very important factor is the length of economic cycles. If you go back to 1854, the average US cycle has lasted 56 months. After 1982, in the "great moderation" the average cycle lengthened to 106 months, almost twice as long. This seems to be down to credit availability; in the absence of a gold standard, the authorities could ease policy and stave off recessions.

But if we have reached the end-game of the debt super-cycle, then recessions will be more frequent. The last recession started in December 2007; if the cycle is 56 months, the next one is thus due in August 2012, less than two years away. Such short, sharp shocks make high-yield bonds look a very bad investment. The asset category changed in character during the great moderation; junk bonds used to be investment grade bonds gone bad, but after the mid-1980s, companies issued primary debt at junk yields. An economic cycle that lasts almost nine years gives investors a chance to earn their yield and get out before the bust; a cycle that lasts less than five years makes that much more difficult. The same principle applies to private equity.

Readers' comments

We would be better off with more frequent, milder recessions to correct our excesses before they get too large to adjust without a crisis. The Greenspan Put put off the day of reckoning, but guaranteed that it would be a catastrophe when it came.

Your post hits at something which is commonly ignored, at least in the US: that cost is an incentive. The arguments here are dominated by Laffer Curve misconceptions, that lowering taxes means lowering costs means more growth means more revenues, etc. The idea has been twisted over time to become a caricature that taxes are always bad and lowering them is always good.

But taxes are just a cost. And a cost imposes a requirement. We recognize that education requires standards, meaning we understand that imposing a cost to advance, to succeed, to do well requires a person to do more, to focus better, to study more. Germany seems to understand this better than most countries; they have adapted to a high cost regime by focusing more on doing well, which means adding value through engineering and focusing more to generate higher productivity. This has turned them into the largest exporter, with 1/4 the US economy.

Costs require innovation. This is why I find the simplistic, mostly GOP message about always lowering taxes as being essentially negative. If you don't believe in America, then you must lower costs because Americans can't compete through innovation and productivity and so must struggle with the poorer nations to make a buck. In the nearly theological message of tax cuts, the implicit idea is that you don't have to be good, you don't have to be particularly competitive, if only you reduce your costs because that way you can make a living, a lousy living but a living, selling lower end stuff for not that much. This is exactly the way poor economies in the 3rd World works except the US has a better infrastructure ... at leas now because we have an infrastructure, both physical and institutional, built by taxes, by much higher taxes. It won't take that long for it to run down, especially if the GOP succeeds in its destructive quest to turn the entire US budget into Social Security, Medicare (for the better off) and the military.

Great response jomiku. I'll second my concern with a growing conglomeration of voters and decision-makers who are willing to sacrifice investment (in physical and human infrastructure) for short-term stability. We were once a country that understood the trade off between sacrifice and forebearance today and a better future tomorrow. Sadly the action behind that understanding has evaporated, though the hollow soundbite still pays false homage.

Upon a time the baseline assumption was that investment was sacrosanct and consumption was variable with the economy's ups and downs; now we've flipped over on that wisdom. Consumption is the thing that must be preserved, and investment the 'nice to have' category that catches any leftovers (and even the leftovers are too often given to pork barrell projects not necessarily the nation's highest real investment priorities).

Great post.
I make two points:
1. Of course dividends are important. Investors deserve to be paid for their capital. Receiving a dividend is much more efficient than selling 5% of ones shares each year. I haven't heard of a bank that likes to wait several years before being paid its interest. When a company is investing in itself, it is cheaper to reinvest profits than find new capital, but periods of heavy investment should be short, not an ongoing endless event. In my experience, people who suggest otherwise are usually conmen, trying to justify something unreasonable.

2.If we have reached the end game of the super-cycle (final paragraph), & recessionary cycles are to become more frequent, they should become more frequent than average. If the period has been less frequent than average for 25-30 years of increasing liquidity, then the tightening period should be more frequent than average. Otherwise the average will not be maintained. If your supposition is correct, we must expect recessions far more frequently than 56 months.

This is so obvious. I work for one of the largest oil companies in the world, as an engineer. I see this phenomena at work every day. I guess liberal arts majors need to have things explained in a more simple way.

"So did earnings grow faster once companies cut their payouts? Up to a point. The real rate of earnings growth edged up from 1.3% to 1.8% a year but that failed to compensate investors for the fall in the average dividend yield from 5.2% to 3.2%."

Someone didn't bother to do the math: The increase from 1.3% to 1.8% is 38.5%; the decrease from 5.2% to 3.2% is 38.5% So where is the failure? Don't the numbers substantiate rather than disprove the widely held view? The Economist usually writes to a higher standard and owes readers a follow up.

As highlighted in Eric D Beinnocker's excellent "The origin of Wealth" luck plays a much bigger part, than most people believe, in determining who gathers in the winnings and who struggles without succeeding.

Managers are human and conditioned to believe that any success is down not to luck but to their judgement and above average ability so like the gambler on a winning streak they increase the risk and eventually turn in sub par performance or are bust.

Past performance comparisons are interesting but in my eyes human nature is more predictable so I will continue to take the dividends and spend them or reinvest in another asset class with hopefully a continuing weak correlation.

Although the math from briarhill is correct, I am not so sure about his comment.

For me it seems that the fact that the percentage increase of real rate of earnings growth is equal to the percentage decrease of the average dividend yield is just coincidence.

But, for economic terms it makes a difference. If you use the Gordon Growth Model (Dividends Discount Model) to calculate some examples, changing these two assumptions in the model, you get different valuations.

I'd like to see a study comparing performance of companies with and without dividends, adjusted for size & balance sheet characteristics. I wonder to what extent dividends seem to matter simply because companies that have them are typically bigger and more profitable than the average company - but how about as compared to companies that are comparable in every way, except for dividend payout?